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18Extending the Analysis of Aggregate
Supply
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
From Short Run to Long Run
• Short run
• Input prices inflexible
• Upsloping aggregate supply
• Long run
• Input prices fully flexible
• Vertical aggregate supply
• The transition?
LO1 18-2
From Short Run to Long Run
• Production above potential output:
• High demand for inputs
• Input prices rise
• Short run aggregate supply shifts left
• Return to potential output
• Production below potential output
• Graphical examples…
LO1 18-3
From Short Run to Long Run
P3
P1
P2
P3
P1
P2
Real Domestic Output Real Domestic Output
Qf
Short-RunAggregate Supply
Long-RunAggregate Supply
a1
a2
a3
b1
c1
Pri
ce L
evel
Pri
ce L
evel
AS3
AS2 AS1ASLR
Qf Q2Q3
AS1
a1
a2
a3
LO1 18-4
From Short Run to Long Run
Real Domestic Output
Long Run EquilibriumP
rice
Lev
el
P1
Qf
a
AS1ASLR
AD1
LO1 18-5
Extended AD-AS Model
Real Domestic Output
Demand-Pull Inflation P
rice
Lev
el
P1
Qf
a
AS1ASLR
AD1
AD2
AS2
c
bP2
P3
Q2
LO2 18-6
Extended AD-AS Model
Real Domestic Output
Cost-Push Inflation P
rice
Lev
el
P1
Qf
a
AS1ASLR
AD1
AD2
AS2
b
c
P2
P3
Q2
LO2 18-7
Extended AD-AS Model
Real Domestic Output
RecessionP
rice
Lev
el P1
Qf
a
AS1ASLR
AD1
AD2
AS2
b
c
P2
P3
Q1
LO2 18-8
Extended AD-AS Model
• Explaining ongoing inflation
• Ongoing economic growth shifts aggregate supply
• Ongoing increases in money supply shift aggregate demand
• Small positive rate of inflation
LO2 18-9
Pri
ce
Le
ve
lReal GDP
Ca
pit
al
Go
od
s
Consumer Goods
Economic Growth, Ongoing Inflation
Productions Possibilities
Long Run Aggregate Supply
Increase in production possibilities
Increase in long-run aggregate supply
LO2 18-10
P1
P2
Q2Q10
Pri
ce l
evel
Real GDP
ASLR1 ASLR2
AS1
AS2
AD1
AD2
U.S. Growth
LO2 18-11
Inflation and Unemployment
• Low inflation and unemployment
• Fed’s major goals
• Compatible or conflicting?
• Short-run tradeoff
• Supply shocks cause both rates to rise
• No long-run tradeoff
LO3 18-12
The Phillips Curve
Real Domestic Output
Pri
ce L
evel
0
P0
P1
P2
P3
Q0 Q1 Q2 Q3
AD0
AD1
AD2
AD3
AS
LO3 18-13
0
1
2
3
4
5
6
7
0 1 2 3 4 5 6 7
Unemployment Rate (Percent)
An
nu
al
Ra
te o
f In
fla
tio
n (
Pe
rce
nt)
0
1
2
3
4
5
6
7
0 1 2 3 4 5 6 7An
nu
al
Ra
te o
f In
fla
tio
n (
Pe
rce
nt)
Unemployment Rate (Percent)
• Demonstrates short-run tradeoff between inflation and unemployment
69
68
6766
65
64
6362
61
Concept Empirical DataData for the 1960s
The Phillips Curve
LO3 18-14
• 1960s economists believed in stable, predictable tradeoff
• Phillips curve shifts over time
• Adverse supply shocks 1970s
• OPEC oil price shock
• Stagflation
• Stagflation’s demise 1980s
The Phillips Curve
LO3 18-15
The Phillips Curve
• No long-run tradeoff between inflation and unemployment
• Short-run Phillips curve
• Role of expected inflation
• Long-run vertical Phillips curve
• Disinflation
LO4 18-16
The Phillips Curve
LO4
14
13
12
11
10
9
8
7
6
5
4
3
2
1
An
nu
al r
ate
of
infl
atio
n (
per
cen
t)
Unemployment rate (percent)
18-17
The Phillips Curve
The Misery Index, Selected Nations, 1999-2009
15
10
5
1999 2001 2003 2005 2007 2009Source: Bureau of Labor Statistics,stats.bls.gov
LO4 18-18
The Long-Run Phillips Curve
3 4 5 60
3
6
9
12
15A
nn
ual
Rat
e o
f In
flat
ion
(P
erce
nt)
Unemployment Rate (Percent)
PCLR
PC3
PC2
PC1
a1
b1
a2
a3
b2
b3
c3
c2
LO4 18-19
Taxes and Aggregate Supply
• Supply-side economics• Tax incentives to work• Tax incentives to save and invest• The Laffer curve
Tax
Rat
e (P
erce
nt)
Tax Revenue (Dollars)
100
m
0
n
l
m
Laffer Curve
MaximumTax Revenue
LO5 18-20
Taxes and Aggregate Supply
• Criticisms of the Laffer curve
• Taxes, incentives, and time
• Inflation and higher real interest rates
• Position on the curve
• Rebuttal and evaluation
LO5 18-21
Taxes and Real GDP
• New findings suggest tax increases reduce real GDP (Romer and Romer, 2008)
• Positive output shocks raise tax revenues
• Difficult to separate the effects of tax changes from other effects
• Investment falls sharply in response to tax changes
LO5 18-22
